Economic Problems

1. Scarcity, choice and the basic economic problem

2. Opportunity costs, allocation of resources
3. Production possibility curve and productive efficiency
4. Growth and the factors of production, land, labour, capital,
enterprise; growth
5. The division of labour and specialization
6. Positive and normative statements
7. Markets versus planning, free-market system, command economy
8. Systems of ownership; capitalism and socialism
9. Economic models
Scarcity, choice and the basic economic problem

 Inflation, unemployment, pollution, energy shortages and

government deficits are some of the complex problems confronting
an economy, which have an impact at the micro level also. These
problems arise due to the fact that resources are limited while
human wants are unlimited. This leads to dissatisfaction, causing
human being to look for ways to fulfill their needs. Thus scarcity
leads to the necessity of making choices. Problems of choice arise
at all levels - at the level of the individual, at the level of producers,
and at the level of the overall economy. The problem here is to find
a method to maximize the level of satisfaction, with the resources
available. Let us now look at how consumers, producers and
governments try to satisfy their needs.
 Scarcity results when natural resources, human resources and capital resources are not
available in sufficient quantity to satisfy all wants. So a producer has to decide what he
wants to produce using a particular resource. For example, if he chooses to produce
paper for textbooks from a stand of trees, then no other product can be produced from
that particular stand of trees. Yet, there are many other products that could have been
produced using the same natural resource, which are also desired by consumers. The
opportunity cost of the decision thus becomes an important consideration; by making a
choice, the next best alternative good cannot be produced.
 Consumers typically make their decisions based on two considerations- budget
constraints and personal preferences. A budget constraint is the difficulty a person faces
when he tries to satisfy his unlimited wants with a limited income. Thus, a purchase
decision is based on income, price, and personal tastes and preferences.
 A consumer can have a choice of alternative products with a limited income if he can find
a person with whom he can exchange goods or services. By means of such exchanges,
he can increase his level of satisfaction. Such gains in satisfaction can be termed as
‘gains from trade’.
 Such exchanges are also possible for producers. Although two producers may both be
capable of producing two products, each can also choose to produce the one product in
which he has a comparative advantage over the other.
 To make the best use of economic resources, the following questions need to be answered:
 What to produce?
 How to produce?
 For whom to produce?
 These questions need to be asked because resources are scarce, and can be put to alternative
uses. Let us now examine these questions in greater detail.
 What to produce?
 At the level of the government, scarcity of land, labor and capital means that they cannot satisfy all
the needs of the economy. They have to choose which goods and services to produce, with the
limited resources available. From an individual’s point of view, he or she has to decide how much
to consume and how much to save.
 How to produce?
 This looks at the combination of resources and the quantity of each resource to be used to produce
a given level of output. The best combination is the full employment of the available resources, to
produce the maximum output. Depending on the resources available, techniques of production can
be labor intensive or capital intensive.
 For whom to produce?
 This refers to the distribution of goods and services between different categories and sections of
the population. For example, one needs to see if the scarce resources are being used appropriately
to cater to the needs of the higher income groups and the lower income groups.
Opportunity costs, allocation of resources

 Opportunity cost can be defined as the cost of any decision measured in terms
of the next best alternative, which has been sacrificed. To illustrate the concept
better, let us assume that a person who has Rs. 100 at his disposal can spend it
on either of the three options: having a dinner at a restaurant, going for a music
concert or for a movie. The person prefers going for a dinner rather than to the
movie, and the movie over the music concert. Hence, his opportunity cost is
sacrificing the movie, the next best alternative once he goes for a dinner. If we
carry forward the same example at the firm level, a manager planning to hire a
stenographer may have to give up the idea of having an additional clerk in the
accounts department. This is applicable even at the national level where the
country allocates higher defense expenditures in the budget at the cost of using
the same money for infrastructural projects. In order to maximize the value of
the firm, a manager must view costs from this perspective.
 Production possibility curve and productive
efficiency

 Now let us analyze how individuals, producers and other economic agents use the
scarce resources to meet the unlimited needs. This to a large extent is possible
with the help of the production possibility curve (PPC). The production possibility
curve can be defined as a curve which shows the maximum combination of output
that the economy can produce using all the available resources.
 The production possibility curve helps us understand the problem of scarcity
better, by showing what can be produced with given resources and technology.
Technology is the knowledge of how to produce goods and services.
 The following assumptions are made in constructing a PPC:
 The economic resources available for use in the year are fixed.
 These economic resources can be used to produce two broad classes of goods.
 Some inputs are better used in producing one of these classes of goods, rather
than the other.
 Technology remains unchanged during the year.
Production Possibilities Sugar ( in Tons) cloth (‘000 mts)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
 Growth and the factors of production, land, labour,
capital, enterprise; growth
 The division of labour and specialization
 Positive and normative statements
 Another debate about the nature of economics is whether it is a positive or a
normative science. According to J. M. Keynes, “A positive science may be
defined as a body of systematized knowledge concerning what is. A normative
science or regulative science is a body of systematized knowledge relating to
the criteria of what ought to be and concerned with the ideal as distinguished
from the actual.....The objective of a positive science is the establishment of
uniformities; of a normative science, the determination of ideals.”
 Positive economics explains economic phenomena according to their causes
and effects. At the same time, it says nothing about the ends; it is not concerned
with moral judgments. On the other hand, normative economics explains how
things ought to be. According to Milton Freidman, positive economics deals with
how an economic problem is solved; normative economics on the contrary deals
with how the problem should be solved. A positive statement is based on facts.
A normative statement involves ethical values.
 Markets versus planning, free-market system,
command economy

 Market Economy
 This economic system emphasizes the freedom of individuals as consumers
and suppliers of resources, and allows market forces to determine the
allocation of scarce resources through the price mechanism. Based on
market demand and supply, consumers are free to buy goods and services of
their choice and producers allocate their resources based on the demand.
Decisions made by producers and consumers are influenced greatly by price.
 Price plays a major role in a market economy. The role of the government is
negligible: consumers choose the goods they want and producers allocate
their resources based on the market demand for different products.
 In such a system, efficiency is achieved through the profit motive. Producers
make goods at the lowest cost of production, and consumers get higher value
goods and services at lower prices. The United States is an example of a
market economy
 Command Economy
 In a command economy, all the economic decisions are taken by the
government – what to produce, how to produce and for whom to
produce. Thus, all decisions, from the allocation of resources to the
distribution of end products, is taken care off by the government. In
this type of systems, efficiency can be achieved only when demands
are accurately estimated and resources allocated accordingly. The
USSR was an example of a command economy. The government
had complete control over the economy, and consumers were just the
price takers. The government set output targets for each district and
factory and allocated the necessary resources.
 Incomes are often more evenly distributed in a command economy, in
comparison to other types of economies. Prices are controlled and
this allows for greater equality in the economy. Decisions are not
based on individual tastes and preferences, but on national goals.
 Mixed Economy
 A mixed economy is a combination of a free market economy and
a command economy. Here, government controls the price
fluctuations to achieve certain objectives such as high level of
employment and low level of inflation. A mixed economy uses
cost-benefit analysis to answer the fundamental questions
discussed earlier - what, how, and for whom to produce. A cost
benefit analysis helps to assess the full costs and benefits to
society arising from a particular decision or project. Decisions or
projects affecting the economy as a whole are taken or accepted
only when the social benefits from the decision of project are
greater than the social costs.
 In a mixed economy, the government organizes the manufacture
or provision of essential goods and services such as education
and health care.
Economic models

 Economic models is a set of equations or relationships used to summarize

the working of the national economy or of a business firm or some other
economic unit. Models may be simple or complex and they are used to
illustrate a theoretical principle or to forecast economic behavior.
 Economic models can be further classified into Micro Economics Models
and Macro Economic Models.
 Micro Economic Models: Models when they incorporate individual
economic units such as households and firms, often grouped into
individuals markets and industries and the relationship between them are
called as micro models.
 Macro Economic Models: these models are used to explain and predict
the working or performance of the economy as a whole, e.g changes in
the level of NI, the level of employment and inflation.
What Economists Do
The economy can be looked at with either a micro
or a macro view.
Microeconomics vs. Macroeconomics
What Economists Do
Microeconomics and Macroeconomics
 Microeconomics is the study of individual people and
businesses and the interaction of those decisions in the
market.
 Studies:
Prices and Quantities
Effects of government regulation and taxes
What Economists Do
Microeconomics and Macroeconomics
 Macroeconomics is the study of the national economy
and the global economy as a whole.
 Studies
Average prices and total employment, income, and
production
Effects of taxes, government spending , a budget deficits on
total jobs and incomes
Effects of money and interest rates
Micro Economics
Microeconomics studies the economic behavior of
individual entities such as individuals, households,
firms, industry, etc.
Microeconomics explains the inter-relationships
between economic units like consumers,
commodities, firms, industries, markets, etc.
Microeconomics analyzes the conditions for
efficiency in consumption and production.
Microeconomic theory describes product pricing
which explains the theories of demand, production,
and cost; factor pricing which explains concepts of
wages, rent, interest, and profit; and the theory of
economic welfare.
Understanding microeconomics helps a great deal in
individual decision making i.e., managerial decision-
making.
Microeconomic analysis helps in addressing the
problems related to the quantity to be produced, the
procedure to be followed for production of goods, and
the final consumers for the goods produced.
Macro Economics
Macroeconomics studies the economy as a whole.
Macroeconomics explains about the total national
income, aggregate demand and supply, general price
level, total employment, etc.
Macroeconomics analyzes the fluctuations and trends
in the overall economic activity in a country and/or
between various countries in the world.
Macroeconomic theory describes the theory of
income and employment to explain economy-wide
consumption and investment, the theory of the
general price level and inflation, theories of economic
growth, and the macro theory of distribution.
Macro economic study is vital in the formulation and
execution of economic policies by government.
Macroeconomic analysis includes study of national
aggregates of output, income, expenditure, savings
and investment.
Economic Science
Economists attempt to discover an explanation for
how economic systems work.
Economists distinguish between Positive
Statements and Normative Statements
Economic Science
Positive statements are about what is.
 can be proven right or wrong
 can be tested by comparing it to facts
Normative statements are about what ought to be.
 depend upon personal values and cannot be tested
MARGINAL VALUE

The marginal value of a dependent

variable is the change in this dependent
variable associated with a 1-unit change
in a particular independent variable
Maximization occurs when marginal
switches from positive to negative.
 If marginal is above average, average is
rising.
 If marginal is below average, average is
falling.
 Graphing Total, Marginal, and Average
Relations
 Deriving Totals from Marginal and Average
Curves
 Total is the sum of marginals.
 Relationship between output and profit

OUTPUT TOTAL MARGINAL AVERAGE

PER DAY PROFIT PROFIT PROFIT
0 0
1 100 100 100.0
2 250 150 125.0
3 600 350 200.0
4 1000 400 250.0
5 1350 350 270.0
6 1500 150 250.0
7 1550 50 221.4
8 1500 -50 187.5
9 1400 -100 155.6
10 1200 -200 120.0
 Total, marginal, and average profit

2000
TOTAL
1500
PROFIT
1000
PROFIT

MARGINAL
500 PROFIT
0 AVERAGE
PROFIT
-500 0 5 10 15

OUTPUT PER DAY

Incremental Concept in Economic Analysis

 Marginal v. Incremental Concept

 Marginal relates to one unit of output.
 Incremental relates to one managerial decision.
 Multiple units of output is possible.
 Incremental Profits
 Profits tied to a managerial decision.
 Incremental Concept Example